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Investing in Preferred Stock: What You Need to Know

With yields on bonds and CDs so low as to almost be insulting, investors are finding themselves searching for income in places they might normally have never thought to look.

I’ve written extensively about dividend paying stocks and about dividend-focused ETFs in particular. Today, I’m going to cover an asset class that has historically been the domain of pension and endowment funds: preferred stock.

If you’re not entirely sure what preferred stock is, don’t feel bad. Chances are good that your broker or financial advisor has never mentioned it to you, and you’re not going to read about them in the financial pages or hear about them on CNBC.

Preferred stock is not “stock” at all, at least in the way you are accustomed to thinking about it. Preferreds are hybrid securities that behave more like bonds than common stocks. Though the features vary from issue to issue, most preferreds fit the following description:

They pay a high dividend that generally does not change over the life of the security, making it similar to bond interest. This dividend is not “guaranteed,” though it generally has to be paid before common stock dividends can be paid.

Bondholder claims rank higher than preferred stockholders in both their regular interest payments and in assets in the event of liquidation, but preferred stockholders rank above common stockholders.

Preferred stock carries no voting rights.

Preferred stock can be converted to common stock under certain conditions.

Preferred stock can often be callable at a given price at the company’s discretion. Some preferred shares have fixed redemption dates, which are similar to a bond’s maturity date.

Preferred stock is often cumulative, meaning that missed dividends have to be made up later.

When you research potential investments in preferred stock, you approach them differently than you would regular common stock. For example, if you bought preferred shares rather than the common shares of General Motors (GM), you wouldn’t particularly care if the company beats or misses earnings next quarter. Your only real concern is that the company earns enough cash to cover its preferred dividend.

Interest rate risk is also a far greater concern. Remember, unless you buy at a deep discount to the call price (which is rare), the dividend is your only source of return. A long period of rising rates could leave you with capital losses that you might never recover. And frustratingly, the flip side of this relationship isn’t always true. Depending on the preferred issue, you don’t necessarily get to benefit from prolonged falling rates. In the case of callable preferreds, the company has the right to buy the stock back at the call price. It hardly seems fair, but investors suffer the pain of rising rates without enjoying the benefits of falling rates.

And finally, you have to consider why a company would issue preferred stock at all. Preferred stock dividends are not “expenses” in an accounting sense. So why wouldn’t a company just issue bonds and benefit from the tax write-off that comes with interest expense?

The uncomfortable answer is that they are often already loaded with debt. This is particularly true of the financial sector, where banks use preferred stock as a way to appease regulators who require a certain percentage of “Tier 1” capital.

So, preferred stocks are not for everyone. They can even be a little tricky to buy for the uninitiated, as many do not have standard ticker symbols. You have to look them up by cusip number instead, which may require the assistance of a broker depending on which brokerage house you use.

Even with all of these caveats, many investors are attracted to preferred shares for the high current income. If you are building a diversified income portfolio, preferred stock can certainly have a place. But I recommend dividend paying stocks as the mainstay, complimented by a traditional bond ladder.

Information is provided 'as is' and solely for informational purposes, not for investment purposes or advice.BrightScope is not a fiduciary under ERISA. BrightScope is not endorsed by or affiliated with FINRA.